What is stagflation and should we be concerned about it?


The steepest inflation in four decades and severe product shortage have drawn comparisons to the US economic slump of the 1970s. The echoes revive concerns about “stagflation,” a term coined in that earlier era that has become synonymous with double-digit price increases, job losses and images of motorists queuing for gas.

“The risk of stagflation is significant today,” according to the World Bank warned in this week. “Several years of above-average inflation and below-average growth are now likely.”

The latest US government data show that consumer prices in May increased by 8.6% year-on-year – the biggest rise since 1981 and a blow to hopes that inflation has peaked. Here’s what you should know about stagflation and the potential risk it poses to the American economy.

What is stagflation?

Strictly speaking, stagflation refers to a phase of rising unemployment combined with sharply rising prices.

More recently, however, economists have used the term more broadly to denote a period when inflation remains much higher than the Federal Reserve’s 2% target and the economy slows or even shrinks. Even if unemployment doesn’t rise, experts warn, a prolonged period of rising costs and stagnant job growth could be devastating.

High prices are straining household budgets and reducing consumer spending, while the sluggish economy means companies are growing slowly, if at all, and corporate profits are collapsing. Financial markets are also suffering as both stocks and bonds fall in value, said Andrew Hunter, chief US economist at Capital Economics.

“It’s ultimately the worst of all worlds for the economy,” Hunter said.

World Bank warns of increasing risk of stagflation if growth slows


When was the last time stagflation occurred?

In the 1970s, this toxic stew of high unemployment and high inflation persisted for over a decade in the US, UK and parts of Europe.

The OPEC oil embargo in 1973 and a drop in oil production after the Iranian revolution of 1979 ended the decade. After the oil-exporting Arab nations stopped exporting oil to the US, the price at the pump quadrupled and oil was in short supply. High energy prices drove up the cost of producing goods and slowed the economy. Between 1973 and 1975, the country’s unemployment rate doubled to 9%. Annual inflation peaked at 14% and did not decline significantly until the early 1980s after the Federal Reserve, led by Paul Volcker, hiked interest rates.

“It’s been a very turbulent time for the economy — you’ve had a number of recessions and overall GDP growth has been pretty weak,” Hunter said.

Will the 1970s repeat itself?

As in the 1970s, supply shocks have significantly worsened inflation over the past 18 months. COVID-19 played a big role as exporting nations shut down or curtailed production of cars, electronics and other goods, and shipping companies took months longer to deliver them.

Meanwhile, the Russian invasion of Ukraine in February, after a year of lower global oil production, has caused energy price increases similar to those of the 1970s, Hunter said.

In contrast, the US economy has also performed in important ways since the 1970s, making it less certain that we will see a repeat.

It is worth noting that while energy costs are still important to developed countries, they are less important today than they used to be. In the USA, 70% less oil is needed for every dollar of economic output than in the 1970s.

“Modern economies use oil much more efficiently today than they did in the 1970s, and a much larger proportion of GDP is made up of the provision of services,” said Sandy Batten, Haver’s senior economist, in a recent presentation.

Policy makers are also more attuned to inflation today than they were four decades ago. Most central banks today have numeric targets, making them less likely to miss runaway inflation and allow it to ‘root’ with consumers. Meanwhile, the economy continues to show resilience, even if the fundamentals of growth appear more fragile. Consumers continue to spend at a healthy level despite higher prices, and businesses continue to hire employees.

In short, the economy is not facing stagflation right now, Hunter and other economists told CBS MoneyWatch, although slower growth is a concern looking ahead.

UN cites war in Ukraine over grain shortages


How likely is stagflation to return?

So far, economic data shows that inflation may have peaked while consumer spending remains strong. Online prices fell in May for the second month, Adobe Analytics reported in this week. And wage increases, a factor in rising prices, are also slowing.

But the war in Ukraine and a global food shortage could create conditions that will cause prices to accelerate.

“Global factors driving up prices, particularly energy prices… could potentially keep inflation high or continue to rise even as the domestic economy begins to weaken,” Hunter said.

And if price increases stay high long enough, consumers could start to expect ever-rising prices as the new normal and change their behavior accordingly, creating a self-fulfilling inflationary cycle.

Can the US avoid stagflation?

According to economists, there are two main ways that inflationary pressures can ease. If supply chain problems eased and autos, electronics, groceries and fuel became more plentiful, prices would fall quickly, said Chester Spatt, professor of finance at Carnegie Mellon University’s Tepper School of Business.

From the Federal Reserve’s perspective, the best way to avoid stagflation is to raise interest rates high enough to dampen consumer demand. That’s what the Fed did under Volcker in the 1980s, and while he’s hailed as a hero among central bankers, a series of recessions that followed as the Fed prioritized fighting inflation over job growth closed that period for most Americans a painful time.

“They don’t have as many tools to solve the problems in the supply chain. But that means the demand adjustments have to be even harder,” Spatt said. “I think we’re going to see higher interest rates to reduce demand — reduce demand from businesses, reduce demand from consumers.”

So far this year, the Fed has raised its target interest rate twice and appears poised to raise it at least three more times by the end of 2022. Higher borrowing costs have already impacted the housing market as mortgage rates rise from around 3% in January to 5% today. Data shows that the number of mortgage applications is being drastically reduced while home purchases are slowing.

The risk is that the Fed’s interest rate hikes will dampen growth rather than just drag it down and trigger a recession.

“You have to reduce demand. But with inflation at 8%, they have to cut demand sharply,” Spatt said. “Can they do this without sliding into a recession? That is a huge challenge.”


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